Bond (noun) bonds
Back in August I explained why the word ‘bond’ caused so much confusion between advisers and clients. Simply put it can refer to a myriad of financial contracts.
In the first part of this series I discussed the various types of fixed term bonds offered by virtually all high street banks and building societies.
In this second instalment I will concentrate on Corporate and Government Bonds. Although these two types of investments typically make up most of the total global economic debt at any one time there are numerous versions and ‘grades’ of these bonds. These can include but are not limited to the following:
- Government Bonds often referred to as Gilts
- Corporate bond – rated from ‘AAA’ through Investment Grade down to High Yield or ‘Junk’
- Index Linked Bond
- Convertible Bond
- Zero Coupon Bond
- Catastrophe Bond
- Callable bond
- Municipal Bond
- Permanent Interest Bearing Shares
- Preference Shares
The sole reason for bonds been issued or offered for sale in the first place is in order to raise capital. For companies this is usually for expansion and growth whilst typically for Governments, states or supranationals it is to fund infrastructure, manage cash flow or put simply to balance the books.
A bond is an IOU issued by a corporation, government, or governmental agency to cover money the bondholder has lent. If you own shares in a company, you are a part owner of the company. As a bondholder, you are a creditor. This difference is worth noting because as a creditor and bond holder you would receive payment before any shareholders in the event that the issuing entity was to find itself in financial difficulty. This is one of the main reasons bonds are seen as a safer investment.
Although less exciting than shares, bonds play a critical role in our economy and an important role in every well-balanced portfolio. Returns from bonds are generally lower than company shares (equities); however, they are a much safer investment. Bonds' safety and stability act as a counter to the fluctuations common to share portfolios. Most investors should have a mix of equities and bonds in their portfolio. The more risk you are able and willing to take the higher percentage of equities in your portfolio. The more conservative investor will want a higher percentage of bonds.
While a FTSE listed company might have only one type of share in issue and readily available for purchase it is not uncommon to have ten’s or even hundred’s of different bonds in issue – with varying interest rates or ‘coupons’ and maturity dates depending on - at the time of issue - long term interest rates, financial strength of the company and the economic climate at the time.
The following is a simplified example of a bond in practice and how it could be used as a form of investment. ABC Foods Ltd has outgrown its current operation and wishes to raise £16,000,000 to purchase land and build new offices and a distribution centre in a better location. Due to the concentrated risk the best offer it could find was a consortium of 4 banks prepared to lend £4,000,000 each but at an interest rate of 12% per annum. One investment bank would lend the full amount but in return it wanted 15% per annum. So the company decides to raise the finance themselves and issues multiple tranches, £100,000 minimum, of ABC Foods corporate bonds. Each individual bond would have a nominal or par value of £100.
Their professional advisers have established that with an interest rate of 8% and a repayment term of 10 years, take up would be 100%. The sales process completes. The tranches snapped up by investment companies, pension funds and insurance companies. Going forward every 6 months ABC foods Ltd make interest payments to all their bondholders of £4.00 for every bond in issue. Some time later they move to the new location, they go from strength to strength and 10 years after the date of issuance the loans are repaid in full. In the above example and if the bonds had been issued in 2001 any investor who had held these bonds for the full term would have made a very handsome return through the accumulated interest payments.
One point people are not always aware of is the fact that once bonds have been issued they can be subsequently traded on secondary markets. Predominantly above or below the nominal or ‘par’ value - depending upon market conditions and sentiment. This is how debt is bought and sold around the globe. As interest rates have tumbled around the world to all time lows, due to the effects of the credit crunch the capital values of bonds have increased substantially over the past few years.
Although it is possible to invest in individual bonds; just like share portfolios it is always prudent to hold numerous issues and varieties of bonds in order to reduce risk. As most investors do not possess either the experience or inclination to manage their own portfolios a much easier and often cheaper option is through pooled investment vehicles like unit trusts. These are investment funds professionally managed by experts in the bond or ‘fixed interest’ markets. They can then be placed inside ISA’s and pensions, where the interest payments received are tax free, or within various other tax ‘wrappers’. In these scenarios minimum subscriptions are easily affordable and the interest payments can be distributed to provide investors with a regular income usually considerably higher than interest payments achieved from bank deposits.
If you would like to know more about fixed interest investments or any of the topics covered in this series do not hesitate to contact us for an informal chat.